Published: August 2021
I’ve received a lot of questions lately about how Treasury Inflation-Protected Securities or “TIPS” work in this type of environment, so I figured I’d write a quick piece about it.
In this rather inflationary environment of late, people are curious about how to protect their money, and naturally TIPS seem like a decent choice. Indeed they can be a decent choice, and I own some TIPS myself.
However, they do have some significant issues as well that investors need to be aware of.
How TIPS Work
A US Treasury bill, note, or bond is a debt security issued by the US federal government.
For most types of Treasuries, you buy a bond by giving them a certain amount of principal in dollars, you receive interest payments during the maturation period of that bond, and then you receive your principal in dollars back at the end. It doesn’t matter what a dollar is worth in terms of purchasing power by that point; you receive that amount of dollars back, period.
The problem, of course, is that the US and other countries have experienced certain periods of price inflation that really ate away at the purchasing power of those bonds. At the end of the day, a dollar is just a piece of paper or some bits in a computer that the government says has value, and it usually gets less valuable each year as the supply increases.
This following chart shows the past 150 years of 10-year Treasury note performance, adjusted for the consumer price index. The blue line is the average Treasury yield during the year, and the orange line is the forward annualized inflation-adjusted return you received if you bought the Treasury and held it until maturity in ten years:
The 1910s, 1940s, and 1970s were not kind to Treasury holders. And with Treasury yields as low as they are, investors in this environment don’t have much protection against an inflationary environment here in the 2020s either.
So a Treasury Inflation-Protected Security or “TIPS” goes a step further and promises that you’ll get your principal back in inflation-adjusted dollars, in case one of those highly inflationary periods happens.
With a TIPS, the principal adjusts with inflation (as measured by the consumer price index or “CPI”) and you’ll receive interest every 6 months which also moves up and down with the inflation-adjusted principal. They are sold in terms of 5, 10, or 30 years.
So, suppose you buy a $1,000 10-Year TIPS that is agreed to yield 1% per year when you buy it. That means you’ll get $10/year in interest, and at the end of the ten years, you’ll receive your $1,000 back as well. However, unlike a normal Treasury note, that security will adjust with inflation. So if inflation goes up by 5% next year, then the principal of the note will adjust to $1,050, and the annual interest amount will adjust to $10.50. Whatever the official CPI is, your principal and interest will adjust by over the term of the security.
If deflation (negative inflation) happens, which is very rare, then the interest payment will adjust downward as well. However, even if deflation happens, by the end of the period you’ll still receive at least $1,000 back. In other words, you receive the inflation-adjusted principal or the original principal back, whichever is higher.
Sounds great, right? Not always.
The Problem with TIPS
If TIPS had no downsides, then of course they would be better than normal Treasuries. You get all the characteristics of a Treasury security, plus inflation protection.
TIPS of course do have two main downsides.
Downside 1) Lower Yields
The first downside is that TIPS offer lower yields than their non-inflation-protected equivalents.
At the moment, the normal 10-year Treasury note yields about 1.3%. Meanwhile, the 10-year TIPS note yields about -1.1%. Yep, that’s a negative yield.
Chart Source: St. Louis Fed
In other words, if you buy a TIPS and hold through maturity, you are guaranteed to lose money vs the consumer price index. That 10-year TIPS note will adjust according to prevailing CPI changes, but meanwhile you’ll be earning a negative interest rate on it. So you’ll keep up with official inflation, minus that negative rate. In return for lending the government your money, the government promises to pay you back less purchasing power than you gave it. Ouch.
This also gives us some degree of information about what the Treasury market thinks inflation average will be during the course of the note’s term. If the normal 10-year Treasury yield is 1.3%, and the 10-year TIPS yield is -1.1%, then assuming a rational market, it is telling us that market participants expect inflation to average 2.4% for the next 10 years. That third variable, 2.4%, is the “inflation breakeven”.
Chart Source: St. Louis Fed
Here is where TIPS come in handy as an investment. If the Treasury market thinks inflation will average 2.4%, but it ends up being 6% instead, then the TIPS will outperform the normal Treasury note during its term. It’ll still lose purchasing power thanks to its negative yield, but it’ll lose less purchasing power than a normal Treasury note will.
As an example, let’s say inflation runs hotter than most people think and turns out to be 6% on average for the next 10 years. The 10-year TIPS would do okay; it would keep up with that 6% inflation but the -1.1% negative yield would offset it a bit. However, a normal 10-year Treasury with a yield of 1.3% would do far worse; that gap between what it’s yielding and what inflation ends up being, is far higher.
So, if you expect inflation will end up being higher than the market thinks, or want to hedge against the possibility of that happening, then having an allocation to TIPS in a bond portfolio makes sense. The TIPS doesn’t keep up with inflation at current yields, but protects you from the possibility of excessive inflation.
On the other hand, if inflation ends up being lower than the Treasury market currently thinks it will be during the duration of the security’s term, then TIPS will have underperformed their non-inflation-protected equivalents, thanks to their lower yields. If inflation ends up only being 1% over the next ten years, then it would have been better to buy normal Treasuries.
To summarize, normal Treasury securities are a better hedge against deflation or disinflation, while TIPS can give some measure of protection against excessive inflation. If inflation ends up averaging roughly around where the Treasury market estimates it to be, then the two types of securities will roughly break even.
Also, if you’re a trader and are willing to sell it before it matures, you might be able to make a bit of money from gains in principal. If the yield drops while you hold it, that means the bond itself went up in price, and you could resell it to someone else. That’s true for other types of Treasuries as well of course.
One of the problems with the Treasury market is that it is a “managed” market. The US Federal Reserve creates new bank reserves to buy Treasury securities, including TIPS, in part to ensure that yields remain low and that excess Treasury supply doesn’t overwhelm private demand for them and cause liquidity problems. That helps keep Treasury yields, including TIPS yields, low. This is good for the borrower (the US government), but not great for the bondholders, dealing with negative inflation-adjusted rates.
Downside 2) Reliance on Official CPI
The other downside of a TIPS is that it is reliant on the government’s measure of inflation, the consumer price index or “CPI”, being relatively accurate.
There are many ways to look at it, but overall, more evidence than not suggests that CPI doesn’t quite keep up with real inflation. In particular, capital goods or prime goods, or labor-intensive services, like a quality single family home, a gold coin, a top tier cut of beef, childcare services, healthcare services, and other things like that which have a degree of scarcity and are hard to substitute for, tend to outpace official CPI.
A funny way to describe it is that the things you really need to buy or want to buy, go up a lot faster than CPI, while things that are easily automated, offshored, or digitized tend to go up more slowly than CPI or even go down in price over time. Plus, everyone has their own unique inflation basket anyway, since everyone has a different ratio of goods and services that they buy.
Both of these downsides layer together. If a TIPS yield is negative, it will fail to keep up with CPI. If CPI doesn’t keep up with the basket of goods you want to buy, particularly of capital goods and prime goods/services that are hard to mass-produce, you’ll underperform real inflation even more. Thanks for playing, try again next time.
The short summary here is that TIPS are an inflation hedge, but an imperfect one.
They have negative yields at the moment, and they depend on the government measuring inflation correctly. Within a bond portfolio, they can protect capital in a highly inflationary environment better than many types of fixed income securities, but since the yield is negative, they’ll still lose some money against inflation.
In other words, owning a negative-yielding TIPS in a highly inflationary environment is kind of like winning the NIT. Yeah it’s better than losing the NIT, but it’s not as good as being in NCAA March Madness.
If truly high inflation happens for a long stretch of time, then some basket of hard/scarce assets like gold, silver, industrial commodities, oil, certain types of real estate, and bitcoin are likely to do better than TIPS. However, TIPS have much lower downside price risk than most of those assets. TIPS are a low-volatility way to protect against excessive inflation, rather than a way to profit from inflation, unless you are actively trading the TIPS.
The main type of environment where you would want to own some TIPS is where you are concerned that inflation might exceed consensus expectations, but that you aren’t sure about that, or you are concerned with the valuations or volatility of some of the other inflation-hedging assets. In other words, if you’re willing to lose a point or two against inflation per year for a certain portion of your portfolio in exchange for relative safety, then TIPS could be you.
If we get a highly-volatile period of asset price drawdowns, you could sell some TIPS and buy some of those other types of assets when they are cheap, and in that environment, owning some TIPS would have been helpful. They’re a useful rebalancing tool.
For that reason, I do think TIPS can warrant a position within a diversified portfolio, but an investor should be aware of their limitations. They are less volatile than many “true” inflation hedges, but in return, they don’t completely protect against inflation in all of its typical forms.
Investors can buy TIPS directly from the Treasury, or they can buy TIPS ETFs. These are some of the big ones:
- iShares TIPS Bond ETF (TIP)
- Schwab US TIPS ETF (SCHP)
- Vanguard Short-term TIPS ETF (VTIP)
- iShares 0-5 Year TIPS Bond ETF (STIP)
Shorter duration TIPS have lower volatility than longer-duration TIPS, but usually have lower yields as well.